Octopus

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by Guy Lawson


  IN 1995, the Israels moved into their brand-new house on Buckout Road, in the well-to-do town of Harrison, leaving behind the prefab town house in Bronxville. The house had been custom designed by Sam and Janice with understated elegance. Unlike many of the mini-mansions being built at the time, the house was perfectly proportioned to the lot. There was a low stone wall in front, with a driveway sweeping down to a newly constructed four-thousand-square-foot executivestyle residence. The interior was decorated with the signi!ers of wealth and re!nement—modern art, antique furniture, stainless-steel appliances. In the backyard there was a large gunite swimming pool. A nature reserve was next door, ensuring that the two-acre property would never have a neighbor on the north side. A homebody by inclination, Sam had created a perfect retreat for his young family.

  Sam’s sense of accomplishment and contentment was given new depth with the birth of a son. Sam was elated. For generations, Israel men had followed in the footsteps of their fathers. Traders had become traders, gamblers gamblers, screamers screamers.

  Sam was going to break the pattern. His imperative was to make life di#erent for his son. Sam would be all the things he felt he’d been denied: calm, kind, easy to please.

  Sam would give his children the greatest gift of all: unconditional love.

  BAYOU WAS THE NAME Israel chose for the hedge fund. It was a reference to his New Orleans heritage and the irreverence he loved so much about the Big Easy. Bayou wouldn’t be a pretentious fund run by M.B.A.s with delusions of grandeur. Bayou would be like Sam: informal, unique, brilliant.

  But as the launch neared, money issues began to press in on the Israels. Since leaving Omega, Sam hadn’t been able to rely on a regular paycheck, or the bags of cash he’d made by front-running. Like many Wall Street high rollers, Sam had paid for his house up front in cash. Mortgages weren’t necessary for a trader of his stature, not when he was on the cusp of real !nancial independence. But throwing down more than $600,000 had stretched his resources. He was quickly burning through his savings. To economize and get a tax write-o#, Sam decided to run Bayou from his basement. There would be no boardroom, or pretty assistants, or high-priced art hanging on the walls.

  He purchased inexpensive desks and chairs and installed an Internet connection.

  Days before the fund was going to begin trading, Israel got a call from Stanley Patrick. He was in Brazil, where he could trade legally. He told Sam he had decided not to come home to start Bayou. In a halting voice, he said he was done, out, !nished. The odds of getting caught by the SEC again were slim, perhaps, but he wasn’t willing to take the risk. Sam pleaded with Patrick to change his mind. Sam said he needed Stanley to help him run the trading program. Sam also needed him to !gure out what stocks to buy and sell; Sam had no experience actually picking stocks to trade. He’d always followed the orders of Graber or Cooperman.

  “I can’t do it,” Patrick told Sam. “I just can’t do it. I can’t trade anymore. I can’t pull the trigger. I don’t want to be responsible.”

  “I panicked,” Israel recalled. “All of a sudden I was by myself. I felt like I couldn’t turn back. I’d come this far. I was ready to go. But I’d never been by myself before. I’d always been the number two guy. I was great at pulling the trigger on a trade. I would !gure out how to work the system. But I needed someone to come up with the idea on what to trade. I had no performance record of my own to sell to investors. My record was everyone else’s record. I couldn’t market Bayou as my own. No one was going to invest in a fund run by Sam Israel. I didn’t know what to do.”

  Israel understood his chances of !nding a top-"ight trader were slim. He didn’t have the money or the reputation to attract a player from another fund. The market was booming, and a good position trader could demand a big salary and fat bonus. Sam could o#er neither. Only one person came to mind. In the eighties when he had worked for Graber, Sam had grown close to a trader named Jimmy Marquez. At the time, Marquez had been one of the biggest and best traders in the business. Marquez had run George Soros’s Quantum Fund for two years. He’d traded for the great Michael Steinhardt. For years his trading record had been excellent. A decade younger than Marquez, Sam had been entranced by his contrarian style and knack for picking winners. Marquez called himself a “strong hand” investor. It ran contrary to everything that Sam had been taught. Instead of following trends and taking small pro!ts, Marquez considered himself smarter than others.

  “I don’t assume that the market knows more than I do,” Marquez told Futures magazine in a pro!le. “I don’t give the market that much credit. Securities prices can move around for no good reason. In most cases, when I reevaluate a situation where I’m going against the market, I conclude it is a buying opportunity and I gradually increase my position.”

  But Marquez’s career had taken a disastrous turn in recent years. In the early nineties, he’d opened his own fund, which he named Half Moon Rising. The !rst year it was down 7 percent, the second year, down 40 percent, the third, 25 percent. There was no fourth year. Sam had worked for Marquez at Half Moon Rising for a short while and had witnessed the fall at !rst hand. But Marquez remained a friend, and the failure made it possible for Bayou to hire a trader of real stature. Sam had no other choice.

  Marquez was still a brand name on Wall Street. He was still well known. With a little gentle résumé editing—with some elisions and ambiguous wording and tactical amnesia —Marquez’s trading record could still be made to look sterling to investors who didn’t know the truth.

  “It turned out to be perfect timing for Jimmy,” Israel recalled. “He’d just !nished liquidating his fund—giving people back their money. I thought he’d learned his lesson.

  Jimmy was very bright—one of the brightest people I ever met. He was down on his luck. This was going to be a fresh start for him and for me.”

  As conceived by Israel, Bayou had an unusual structure, based on how Freddy Graber had run his fund. There were two separate entities: Bayou Securities and Bayou Funds.

  Instead of using outside brokers for its trades, like most hedge funds, Bayou Securities would be an independent in-house broker-dealer. By keeping the brokerage business to himself, Israel would capture the revenues from the commissions from his own trades.

  He would also get commissions for making trades for other funds. Bayou Funds was the hedge side of the business; it would trade the money of Bayou’s investors. The structure gave the hedge fund a competitive advantage. The industry-wide standard for paying money managers was called “2 and 20.” This meant that hedge funds charged investors a fee of 2 percent per year of the capital for the cost of running the business. In addition they received a bonus of 20 percent of performance (pro!t) made by the fund.

  Sam’s idea enabled Bayou to o#er a discount to investors. Bayou Securities would generate enough income to enable Bayou Funds not to have to charge 2 percent to defray its administrative costs. The saving was an enticement to investors, but it also spoke to the ingenuity and cost consciousness that Israel was marketing.

  “I started out with high morals,” Israel recalled. “I was sick of all the cheating on Wall Street. Brokers were all trading on their own account, so they had a con"ict of interest with the investors they were supposed to be advising. Then there was the new greed of initial public o#erings. Internet IPOs were coming onto the market every day.

  But they were all !xed games. I didn’t want to get into that world. Because I had my own broker-dealer I wasn’t legally eligible to get stock from the IPOs. I didn’t want it anyway. We were going to do our own work. We were going to do our own trades. We were going to be steady Eddie, hitting singles and doubles, not aiming for the fence.

  That was what Bayou was all about.”

  Israel was the sole owner of the fund, though it was understood that he and Marquez would be equal partners in pay, power, and prestige. As ante money for their enterprise, Israel put in $150,000 of his own money. Marquez did likewise. The books would be kept b
y Dan Marino—an accountant who had worked for Half Moon Rising. Marino was a short, squat, and shy man from Staten Island with a severe hearing impairment.

  Marquez had plucked Marino from obscurity and brought him to Half Moon with the promise that he could run the venture capital business Marquez would start with the pro!ts from the fund. The trader had imagined his personal wealth would exceed $500

  million—a hope that seemed preposterous in hindsight. But the awkward accountant worshipped the ground that Marquez walked on, even after he had failed so spectacularly.

  In March of 1996, Bayou’s incorporation papers were executed by the three main players—Sam Israel, Jimmy Marquez, and Dan Marino. To get started, Israel and Marquez set about the business of raising money. For a start-up hedge fund like Bayou, this meant exploiting every contact possible—friends, family, colleagues. It meant calling in favors, ingratiating yourself, inveigling, pleading. Marquez was able to convince a few investors to put modest sums into Bayou. So was Sam. Together with their own investment, the initial sum Bayou had to trade with was $600,000. It was a pittance but a start.

  The early results for Bayou were promising. Sam worked hard, following the trading patterns dictated by Forward Propagation. Marquez decided what stocks they were going to trade. At the opening bell, Israel went into the market with his buy/sell sheet and traded the positions with discipline. Price movement was how Sam made money. It didn’t matter if they were going up or down. Sam went short and long; he bought stock and he bought options. It seemed like Bayou’s plan was working. In the !rst three and a half months, according to an audit by the !rm Grant Thornton, the fund’s performance was 17.6 percent, net 14 percent pro!t for investors after the 20 percent management fee was taken out. Annualized, that would mean performance of more than a 50

  percent return, an incredible feat.

  With the !rst audited performance report in hand, Israel and Marquez had something tangible to sell. By this time, a man named John Squire had approached Bayou with the idea of selling the fund to investors. Squire worked for a small investment !rm with o$ces on Park Avenue called Redstone Capital Corporation. In a memorandum to an investor, Squire made the case for Bayou in compelling terms. “While three and a half months is a short performance period,” Squire wrote, “I think I’ve seen enough over the years to recognize the real from the unreal. Sam and Jim’s trading program is real—and a little frightening in its accuracy.”

  Squire described how Forward Propagation operated in practice. With a complex market data stream feed from a satellite, the machine was able to predict trading patterns correctly 86 percent of the time. When the data aligned, three colored lines appeared on the screen to show how to trade. “I’ve seen the system work dozens of times,” Squire said. “It’s really fun to watch the two of them at work. The type of investment is irrelevant: They do commodities, foreign bonds, indices, U.S. securities, anything which gives them the right pattern. The type of market—rising or falling—is also irrelevant. Once you are familiar with how the three colored lines work, you can pick situations, too. Sam told me his daughter had a successful morning trading stocks earlier this year while waiting for her school bus. I think his daughter is about !ve years old.”

  By the end of August, Bayou’s performance was running at 19.8 percent. In September it was up to 21.8 percent. In October the Dow passed 6000 for the !rst time.

  Even so, Bayou was beating the market handily. Sam’s dream was coming true. Bayou was developing a good story. In a matter of months, the fund doubled to more than $1

  million. “If you are looking for an interesting form of money-management, may I suggest checking this one out,” Squire wrote to potential investors. “I feel very comfortable with it.”

  BUT LUCK WAS A FICKLE mistress for Bayou. As the end of Bayou’s !rst year neared, Marquez decided Bayou should go into gold stocks. Gold was badly undervalued, Marquez believed. When Barrick Gold announced a pact with the Indonesian government to acquire the majority of the largest gold deposit found in decades, Marquez decided the company was a must-buy. It looked like a classic Marquez strategy. Barrick was in partnership with the Indonesian government, then a dictatorship under the decades-long rule of President Suharto. The entire country had e#ectively become a private resource for Suharto to exploit through his yayasan, or foundation—a scam that yielded the family $35 billion.

  To Sam, Barrick looked like an excellent trade. As a boy he’d sat on the knees of his famous grandfather and learned how commodities like gold were controlled in Third World countries. The exotic names of the men his father had dealt with were part of the fabric of Sam’s life—Marcos’s henchman Don-ding Corleone Cojuangco in the Philippines, or Fung King Hey in Hong Kong, who had provided the Israels backdoor access to China’s billions. In those nations, Sam knew, money and power and corruption were inextricably linked. Barrick had stacked its board of directors with high-level politicians, including former president George H. W. Bush, who had been a friend of Sam’s father. Sam believed Barrick was assured of having the ear of Suharto and his entourage. Marquez poured Bayou’s money into Barrick like a riverboat gambler pushing his chips forward in an all-in hand of Texas Hold ’Em.

  But circumstances conspired against Barrick—and Bayou. One of Barrick’s competitors sued, then allegations of graft and market manipulation slowed the deal.

  The forces that Sam had imagined to rule the world were thwarted, at least temporarily.

  Barrick didn’t get the Indonesian gold. The company proved to be one of the very few stocks that went down in the bull market of 1997. To the horror of Marquez and Israel, the market capitalization of the company was cut in half. Gold sank to a twelve-year low of $295 an ounce. Years later, as gold prices soared to unprecedented heights, Marquez would prove to be right—but a decade early.

  As the position unraveled, Israel and Marquez began to bicker. As a distraction, Sam began to construct a play set for his daughter in the backyard of the house on Buckout Road. It was modular, with swings and monkey bars. Sam dug out an area in the yard, spreading wood chips. “Then I bought eight railway ties, the heavy hardwood ones covered with creosote, to create a square around the play set,” Sam recalled. “I put two along each side. I was on the last railway tie when my mother pulled into the driveway for my daughter’s birthday. I was carrying a railway tie that must have weighed a hundred pounds. I turned to say hello and I felt my neck go pop. It was total agony.

  There was a lump on my neck and I couldn’t get it to go down.”

  Incapacitated, Israel saw a series of doctors trying to get relief, but he was unable to trade the way he had because of the pain. Then, in late October, the market su#ered a minicrash when an Asian !nancial crisis triggered a shock wave that ran through world markets. In a matter of days the Dow dropped by 12 percent. More than $600 billion in market value was erased. It was the kind of crash that Sam had been able to capitalize on in 1987. This time, the Asian crisis came like a tsunami, a seemingly random event anticipated by no one—including Sam. Nursing his sore neck, he continued to tinker with the program as he worked nights in his basement trying to !nd a !x for the computer, Bayou, himself.

  At the time it was little understood that it was perversely easy for hedge funds to be dishonest with their investors. Because Bayou’s investors were technically partners, regulators assumed that they had access to !nancial information in a way that a partner would expect. But hedge funds were secretive. The only time investors truly received disclosure about the performance of the fund was when the annual audit was done by an outside accounting !rm. That process occurred only at the end of the year, so Bayou had time to make up the losses before the trading record had to be submitted to an objective third party. In the meantime, Israel and Marquez continued to tell Bayou’s members and prospective investors that the fund was thriving—even when it was losing.

  There was no way to date the !rst deception. Or know with certainty who lied !rst—Marquez or Israel.
They both talked to investors all the time. E-mails were exchanged, phone calls made, reports circulated. Both of the traders told investors that Bayou continued to perform well. They assured their investors that the rate of return—ROR in the industry—was outstanding. Mild exaggerations became stretchers, as Mark Twain called half truths. Outright lies followed. Both men knew that transparency would kill the fund. Neither could live with that prospect. Marquez couldn’t a#ord another failure.

  Sam couldn’t stand the thought of having to go back to Omega, cap in hand, and ask for his job back. Exhorting each other to focus and work harder, they gambled that they could make up the losses before the looming year-end audit. Sam was convinced that Bayou just needed a little time, and a little luck.

  But at the end of the year, Bayou had a net loss of $161,417—a negative performance of 14 percent. It was obvious that as soon as investors learned of the loss, what remained of Bayou’s money would be redeemed. Their baby had been stillborn. The fund would have to close. But then the accountant Dan Marino had an idea—a brilliant idea, one that would provide the foundation for a massive fraud. Bayou’s partnership agreement stated that the broker-dealer “may charge commissions” for trades done by the hedge fund side of the business. The word may meant Bayou had discretion. Why not forgo the commissions? Marino asked. Better yet, why not rebate the commission the hedge fund had paid to the broker-dealer? The traders had lost money, after all.

  Bayou’s auditors were unable to grasp the concept. It sounded like "im"ammery at the same time as it made perfect sense. Grant Thornton was a reputable national accounting !rm. They’d audited countless hedge funds. But Bayou’s structure was di#erent. How to properly reconcile the books of a fund with two companies inside it doing business with each other, like Bayou’s hedge fund and broker-dealer? The usual fear would be that the broker-dealer would overcharge the hedge fund as a way of ripping o# investors. Marino’s suggestion did the opposite. The broker-dealer was going to undercharge the hedge fund.

 

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